538  Corporate Portfolio Strategy The facts refute this argument. First, we haven’t found any evidence that diversified companies actually generate smoother cash flows. We examined the 50 companies from the Standard & Poor’s (S&P) 500 index with the low- est earnings volatility from 1997 to 2007. Fewer than ten could be considered diversified companies, in the sense of owning businesses in more than two distinct industries. Second, and just as important, there is no evidence that investors pay higher prices for less volatile companies (see Chapter 7). In our regular analyses of diversified companies for our clients, we almost never find that the value of the sum of a diversified company’s business units is substan- tially different from the market value of the consolidated company. Another argument is that diversified companies with more stable cash flows can safely take on more debt, thus getting a larger tax benefit from debt. While this may make sense in theory, however, we’ve never come across di- versified companies that systematically used more debt than their peers. A more nuanced argument is that diversified companies are better posi- tioned to take advantage of different business cycles in different sectors. They can use cash flows from their businesses in sectors at the top of their cycle to invest in businesses in sectors at the bottom of their cycle (when their undiver- sified competitors cannot). Once again, we haven’t found diversified compa- nies that actually behave that way. In fact, we typically find the opposite: the senior executives at diversified companies don’t understand their individual business units well enough to have the confidence to invest at the bottom of the cycle, when none of the competitors are investing. Diversified companies tend to respond to opportunities more slowly than less diversified companies. Elusive Benefits, Real Costs While any benefits from diversification are elusive, the costs are very real. In- vestors can diversify their investment portfolios at lower cost than companies can diversify their business portfolios, because they only have to buy and sell stocks, something they can do easily and relatively cheaply many times a year. In contrast, substantially changing the shape of a portfolio of real busi- nesses involves considerable transaction costs and disruption, and it typically takes many years. Moreover, the business units of diversified companies often perform less well than those of more focused peers, partly because of added complexity and bureaucracy. Today, many executives and boards in developed markets realize how dif- ficult it is to add value to businesses that aren’t connected to each other in some way. As a result, many pairings have largely disappeared. In the United States, for example, by the end of 2010, there were only 22 true conglomerates.10 Since then, five have announced that they would split up or divest major businesses, too. 10 J. Cyriac, T. Koller, and J. Thomsen, “Testing the Limits of Diversification,” McKinsey Quarterly (Feb- ruary 2012). Conglomerates were defined as a company with three or more business units that do not have common customers, distribution systems, technologies, or manufacturing facilities. The Myth of Diversification  539 We examined the performance of these conglomerates versus focused companies. The striking insight was not that average total shareholder returns (TSR) was lower for conglomerates, but that the top end of the distribution was chopped off. No conglomerate in our study exceeded a TSR above 20 percent, while the TSR of more focused companies topped out above 30 percent (see Exhibit 28.1). Upside gains are limited for con- glomerates because it’s unlikely that all of their diverse businesses will outperform at the same time. The returns of units that do are dwarfed by underperformers. Moreover, conglomerates are usually made up of rel- atively mature businesses, well beyond the point where they would be likely to generate unexpected high returns. But the downside isn’t limited, because the performance of more mature businesses can fall a lot further than it can rise. Consider a simple mathematical example: if a business unit accounting for a third of a conglomerate’s value earns a 20 percent TSR while other units earn 10 percent, the weighted average will be about 14 percent. But if that unit’s TSR is –50 percent, the weighted average TSR will be dragged down to about 2 percent, even before other units are affected. In addition, the poor aggregate performance can affect the motivation of the entire company and the company’s reputation with customers, suppli- ers, and prospective employees. What Does Matter What matters in a diversification strategy is whether managers have the skills to add value to businesses in unrelated industries. We found three ways high- performing conglomerates outperform. First, as discussed in greater depth Exhibit 28.1  Distribution of TSR by Levels of Diversification Distribution of S&P 500 companies by total shareholder returns (TSR), n = 4611 Annualized TSR, 2002–2010, % % of companies 0 10 5 15 20 25 30 35 40 45 –25 <–30 –20 –5 –10 –15 15 10 5 0 20 25 30 >30 Focused companies Conglomerates,2 excluding financial institutions All conglomerates2 Moderately diversified companies 1 Includes companies in 2010 S&P 500 that were also publicly listed on December 31, 2002. 2 Defined as any company with three or more business units that do not have common customers, distribution systems, manufacturing facilities, or technologies.